Margin Call Plan on Mortgage Bonds Draws Protest: Credit MarketsJody Shenn
The latest effort to lessen the chance of another financial crisis is drawing protests that it will raise the cost of a mortgage in the U.S. and concentrate more risk at the biggest banks.
At issue is a proposal from the Financial Industry Regulatory Authority that would force mortgage-bond dealers to collect cash or other assets as margin to back as much as $1.5 trillion of trades in the days, weeks, or even months, before they’re settled. Such requirements could prevent failures of everything from hedge funds to broker-dealers from rippling through the system by ensuring that their trading partners aren’t left empty-handed.
Finra’s plan would create stricter and more wide-reaching rules than an initiative being embraced by the biggest mortgage-bond players, which see margin calls as a weapon against the interconnectedness that helped freeze credit markets in 2008. Groups representing brokers, lenders and money managers say the latest proposal will boost mortgage rates, squeeze smaller firms from the market and introduce new risks.
“It’d be disruptive to the market on so many levels,” said Robert Fine, the chief executive officer of New York-based investment bank Brean Capital LLC who’s been in the mortgage-bond business for 27 years. “That includes the fact that the rules as proposed would lead to fewer smaller participants in the market, which will mean less liquidity and a less efficient marketplace.”
Along with making trading harder in times of stress rather than bolstering stability, the loss of investors and brokers will depress bond values and raise new loan rates, Fine said. “Ultimately, the prices are established based on what lenders can sell the mortgages for in the marketplace,” he said.
The Securities Industry and Financial Markets Association, Bond Dealers of America, Mortgage Bankers Association and Association of Institutional Investors are among groups that objected to the scope of the rules during a comment period that ended March 28. In letters sent to Finra, they asked the regulator to scale back its proposed requirements for trading in U.S. government-backed mortgage bonds, known as agency securities.
After taxpayers rescued American International Group Inc. in 2008 when it couldn’t make good on soured trades guaranteeing subprime mortgage debt, threatening the world’s biggest banks, regulators have been cracking down in markets where such losses aren’t backed by cash or other collateral.
‘Out of Date’
Broader and firmer margining guidelines are needed to address the “systemic risk” created by open trades, which could lead to cascading disruptions to the market when firms fail, Bill Wollman, an executive vice president of member regulation at Finra, said last month at a New York event on the topic held by Sifma, Wall Street’s largest lobbying group.
“If anything, this market is kind of out of date with other things and where other derivatives are heading,” he said.
The $5.4 trillion market is among the busiest in the world, with $223 billion of daily trading last year, and is being used by lenders to raise money for more than 80 percent of new home loans. As part of its efforts to bolster housing, the Federal Reserve has added $1.6 trillion of the debt to its balance sheet since 2009.
More than 90 percent of agency mortgage transactions occur in what are known as To Be Announced trades, meaning investors don’t immediately purchase the bonds. Instead, they enter forward agreements setting prices at which they’ll buy securities matching certain generic characteristics. Once a month, sellers pick the bonds and buyers hand over the cash.
The set-up makes trading easier, boosting prices, and lets lenders to sell loans weeks before they finish processing them. That allows home buyers to lock in mortgage rates when they submit applications. It also leaves sellers of securities waiting for cash that they may not get if a buyer defaults, at which point market prices for their holdings could be lower. Buyers can also face risks if sellers vanish before trades get completed.
Finra’s proposal would generally ensure that the surviving trading partners have money to at least cover the difference between the price at which they initiated the transaction and the current market level. It follows similar moves by regulators in other markets, including efforts by the U.S. Commodity Futures Trading Commission and Securities and Exchange Commission to push privately negotiated derivatives to clearinghouses that require margin on trades.
While transactions between brokers in the agency mortgage-bond market are usually backed by a clearinghouse that collects margin, about $750 billion to $1.5 trillion of unsettled transactions exist at any given time, Finra said in a proposed amendment to its Rule 4210, citing research by an industry group coordinated by the Federal Reserve Bank of New York.
Finra’s effort would expand on an earlier set of guidelines by the group of major dealers and investors known as the Treasury Market Practices Group. The TMPG developed margining guidelines mostly adopted last year by its members, which include Morgan Stanley, Goldman Sachs Group Inc. and BlackRock Inc., the world’s biggest money manager.
Before any margining rules can be enacted, Finra would need to ask the SEC to publish a potential final version for more public input and approve the rulemaking.
After delays to the TMPG’s timeline, its members were supposed to be “substantially complete” with adopting the guidelines by Dec. 31. At the end of February, they had on average executed agreements with about 55 percent of counterparties, covering about 85 percent of their trading, excluding transactions through clearinghouses, according to the minutes of the group’s March 10 meeting.
Even market participants that support margining in the wake of the crisis that caused the collapse of firms from Bear Stearns Cos. to Lehman Brothers Holdings Inc. see flaws in Finra’s approach.
One difference between the TMPG guidelines and Finra’s proposal is the regulator would force many types of investors to put up 2 percent of the value of securities at the start of trades, not just amounts reflecting changes in prices afterward.
Clients including banks, insurers, pensions and registered investment funds would be exempted from the additional requirement. So would mortgage bankers if a dealer is confident they’re only using trades to hedge the risks of their application pipelines and recent loans, a requirement that Sifma said in a comment letter isn’t feasible.
An exemption would also be available for investors with at least $40 million of assets and financial records available for a dealer to inspect, thresholds that might rope in much of the money invested by even the largest fixed-income managers.
It’s a “serious concern” for Fidelity Investments, which oversees $2 trillion, Donald Caiazza, senior legal counsel in the Boston-based firm’s fixed-income division, said at the Sifma event. One potential problem area would be pools of assets it manages for a pension fund, he said.
Such investors, which would also face significant costs to build and maintain “the legal and operational infrastructure” needed, may scale back their buying or exit the market completely, making it harder for everyone to trade, John R. Gidman, an executive vice president at Loomis Sayles & Co. and president of the Association of Institutional Investors, said in the group’s comment letter.
The damage to smaller brokers would especially reduce liquidity in the types of less common debt they focus on, and hurt the individuals, smaller investors and independent mortgage lenders to which they cater, said Andrew Kowalczyk, chief executive officer at AK Capital LLC.
“Let’s have Wall Street have some sensitivity toward Main Street for once,” he said in a telephone interview.
Collapses could become more plentiful in part because Finra’s rules would require margin to be delivered within a day and, unless an exception is granted by the regulator, for trades to be canceled if it doesn’t show up within five days. Trade groups said pricing disputes could make those timelines impossible, while automatically killing trades could trigger defaults on other agreements, Fidelity’s Caiazza said.
Another potential problem highlighted by brokers: While dealers wouldn’t be required to collect margin less than $250,000, they would still need to deduct those missing amounts from calculations of whether they have enough capital. That figure could add up quickly for small brokers with lots of small accounts, said Rebecca Ebert, managing director and associate general counsel at Sandler O’Neill Partners LP.
“That’s absolutely something that we’re terrified of,” she said at the Sifma event. “You’re talking about wiping out you’re entire market of regional firms on a particularly volatile day.”